Articles of Association (AOA) of the Company is a business as well as a legal document which prescribes rules and bye-laws mandatory for smooth regulation of the affairs of the Company. It is an agreement of paramount significance as it contains the regulations (like issue and rights related to shares, conduct of the company meetings, the role & powers of the directors, etc.) for the internal administration among the shareholders and between the Company & the shareholders so that the attainment of the overall objectives of the company‟s along with its members‟ as given in the Memorandum of Association (MOA) also takes place. The articles are like the partnership deed in a partnership which particularly provides for matters such as the making of calls, forfeiture of shares, directors qualifications, the procedure for transfer and transmission of shares and debentures, powers, duties and appointment of auditors. It is also a public document because the shareholders are presumed to be constructively mindful and vigilant of the regulations stated and/or amendments made in the Articles of Association of the Company.
As per Section 10, the memorandum and the articles when registered shall bind the company and its members to the same extent as if it had been signed by them and had contained a covenant on their part that the memorandum and the articles shall be observed. The AOA is seen as the rule book of the Company but is a subsidiary and must always be in consonance with the MOA of the company, defining the rights, duties and powers of the management of a company as among themselves and the company at large. The articles being subordinate to the memorandum, they cannot extend the objects of a company as specified in the memorandum of the company. The articles can put stipulations on the company‟s powers, which may be gainful if shareholders want to be at ease that the directors will not proceed with certain courses of action, at least without the approval of the shareholder but however, the Companies Act gives a company unlimited powers. So this raises a question that can article be amended and the majority of how many members of the company is required to amend it?
The Companies Act of 1956 did not provide for the Entrenchment Clause, the new Act of 2013 refers to ‘Amendment of specified clauses of Articles of Association’ as the entrenchment Clause. It means that Articles of Association is a constitutional document of the Company and any amendment to the specified Clauses of Articles of Association may require additional conditions to be fulfilled which are referred to as Entrenchment Clauses; also the amendment of specified clauses would include the addition of new clauses in the Articles. An Entrenchment clause in any basic law or constitution is such a provision that it makes certain amendments either more difficult or impossible. As per the Indian Companies Act, 2013 the word Entrenchment is not defined any where, for the concept being new, but according to dictionary meaning and adding a little legal meaning to it as well, Entrenchment means to establish or constitute some provisions firmly and securely, that change is very difficult or unlikely to take place, so as to apply additional legal safeguards. It may require the constitution of mass or referendum governed by the people, or the consent of another party. The word ‘may’ used here indicates that a company is given discretion either to include entrenchment provisions in their articles as per Section 5 (3), (4) & (5) of Companies Act, 2013 or not. Therefore, it can be implied that the provisions of entrenchment may make the current provisions more stringent/cumbersome to follow either by way of procedure or by putting checks and balance in the coming period.
The concept of provision of entrenchment
A Company is a group of persons that come together to create their wealth by making joint and mutual decisions for the benefit of each other, but it is likely that majority shareholders will try to impose their decisions on the others in the working of company, thereby affecting the mutual decision-making power of the shareholders and violating their rights to have a say on matters especially relevant and crucial for them. Therefore, to curb such problems the Companies Act, 2013 has introduced the provisions of entrenchment u/s 5(3) to safeguard the interests of the minority from the peril of super majority so as to prevent the creation of a legal dictatorship. According to Section 5(3) of the Act, the articles may contain provisions for entrenchment to the effect that specified provisions of the articles may be altered only if conditions or procedures as that are more restrictive than those applicable in the case of a special resolution are met or complied with.
In reference to the above provision, it is non-mandatory and open to the choice of the company to incorporate such a clause. However, if the same is incorporated in the articles, then the company can not exercise particular power without complying with the restrictive conditions to be met with for decisions to be passed in case of special resolution. In order to avoid the majoritarian rule of controlling the company at their whims and fancies, the government has inserted Section 58 (2) which gives the companies discretionary power to incorporate the provision of entrenchment in its AOA making it cumbersome and more regulatory for the majority and the people at the helm of the company. The Supreme Court in V.B. Rangaraj v. V.B Gopalakrishnan in this regard has held that a private agreement between shareholders would not bind the Company unless the Articles of Association of the Company provides for such limitations as shares are movable property and their transfer is regulated by articles of company and such an agreement imposing restriction contrary to provisions of articles would not be binding on shareholder and company (as per Article 13 of company in the present case). Therefore, the shareholders cannot enter into an agreement among themselves contrary to the articles of association of the company as the Act provides that the articles are regulations of company binding on the company and its shareholders. Likewise, the entrenchment clause needs to be in agreement with the MOA of the company and the Companies Act, 2013 otherwise it is void, not binding and unenforceable. The additional safety measures provided by the Entrenchment Clause will raise a number of legal issues about their validity and the grounds for reasonableness of such validity is a question of debate. For example, a clause in AOA granting special rights to a minority group in terms of voting or veto power against the wisdom of a majority of shareholders is valid or is such clause against the very basis of corporate democracy of one share one vote and that all shares rank pari passu.
A Company may alter its Articles in accordance with the above provisions in any of the manners mentioned below:
1. By adoption of a new set of articles
2. By addition/insertion of a new Clause(s);
3. By deletion of a Clause(s);
4. By amendment of a specific Clause(s);
5. By substitution of a specific Clause(s).
By amendment, the Company may incorporate the provision of entrenchment as per Section 5(3) as aforementioned. There are 2 types of entrenchment – Absolute and Conditional. Absolute Entrenchment means, unless otherwise the court or tribunal orders, certain provisions are unalterable and impossible to change. This provision is not given in the Companies Act, 2013. Conditional Entrenchment means subject to fulfilment of certain conditions or compliance with specific procedures, certain provisions can be altered. Now, as per Section 5 (4), the provisions for entrenchment referred to in sub-section (3) shall only be made-
1. Either on the formation of a company, or
2. By an amendment in the articles-
2.1 In the case of a private company agreed to by all the members of the company
2.2 In the case of a public company by a special resolution.
When the articles of a company are incorporated with the provision of entrenchment the Registrar of Companies (ROC) has to be notified of such provision in form and manner prescribed as per the Rule 10 of the Companies (Incorporation) Rules, 2014-
1. At the time of incorporation the company shall give notice to the Registrar of such provisions in Form No.INC.2 or Form No.INC.7, as the case may be, along with the fee as provided in the Companies (Registration offices and fees) Rules, 2014, or
2. in case of existing companies, the same shall be filed in Form No.MGT.14 within thirty days from the date of entrenchment of the articles, as the case may be, along with the fee as provided in the Companies (Registration offices and fees) Rules, 2014. Furthermore, entrenchment provision puts articles in a very strong position.10 For example, AS Ventures is a private equity fund who subscribes 10% of equity shares in RT Ptv. Ltd. and the terms of the agreement have been executed for this subscription. Now, RT Pvt. Ltd. can without the consent of AS Ventures do a certain transaction like the issue of shares, the creation of new subsidiaries, borrowing more than limit, etc. In practical life, these rights are called ‘Affirmative Rights or Confirmatory Rights’ which are given to any private equity investor. As a part of the contract, these rights are included in the Articles of RT Pvt. Ltd. The outsiders like the Banks are even aware of such rights given. Tomorrow if RT Pvt. Ltd. approaches any Bank for the loan, then the bank officials would obviously read the articles and would ask to get the consent of AS Ventures. But the problem here is with the control mechanism wherein AS Ventures only holds 10% equity in RT Pvt. Ltd. and what if the other 90% holders by passing a special resolution (as per Section 114) remove the affirmative rights from the articles, then AS Ventures wouldn’t have any control over RT Pvt. Ltd. Now consequently, in the above-mentioned situation, the provision of entrenchment might help preserve the interests of AS Ventures who is a minority here. Therefore, at the time of investing AS Ventures may ask RT Pvt. Ltd. to include provisions of entrenchment in its articles; the reason being this provision stipulates that any affirmative rights like issue of shares, creation of new subsidiaries, borrowing more than a limit, etc., in the articles of RT Pvt. Ltd. can only be done with consent of AS Ventures. Thenceforth, the provision of entrenchment would put articles in such a position that even the affirmative rights would be executed only with the consent of the associate company i.e. AS Ventures in the above example, further providing a strong footing for the minority interest. Likewise, a similar instance of the clause of entrenchment in the articles is covered under Section 163 which involves the principle of proportional representation for the appointment of directors. In this section, the entrenchment clause can act as a rider to put control of the exercising of any such exploitative power used by the majority over the minority. Although, another protection is available under the same section wherein the power is given to the shareholders or the co-venturers or any person to nominate/appoint the Directors on the Board of a company.
Instances where amendment of articles is vio-lative of minority’s interests
The provision of entrenchment has been annexed to give strength to the minority party so as to not allow voluntary decisions by the majority shareholders in the company until the consent of such mediocre party is available if given in the entrenchment provision in Article of association as per the laws. With the entrenchment provision, criteria are to prevent subsequent amendments, once it is adopted which makes some portion of law irrevocable except in cases of the assertion of rights. If the entrenchment clauses of AOA prescribes certain decisions which require the consent of the minority, then the decision cannot be approved without the minority‟s consent. This provides for special privilege to minority‟s consent. With the entrenchment provision, the creation of legal autocracy is prevented, as the majority always enforce their decision on the company. But now minority members can force the majority to appraise the former‟s views in decision making. The doctrine of egalitarianism should be followed wherein there is a balance between the rights of the majority and minority shareholders for the persuasive working of the company. Moreover, the negative aspect of the entrenchment provision involves companies having concentrated ownership structure which weakens the governance mechanisms wherein there is a conflict between two classes of principals i.e. controlling shareholders and minority shareholders (which is quite distinct from principal-agent conflicts). The effectiveness of the entrenchment provision negates the strengthening of the position of minority shareholders when applied by the controlling shareholders for their own benefit. This happens when the majority shareholders amend the AOA by inserting those clauses which are beneficial only to the majority shareholders and applying the tactics in their favour in a manner that they are able to redirect or consume corporate resources that provide benefits to only majority shareholders instead of the minority shareholders. Company having concentrated ownership structure, the promoters were the controlling shareholders of the company and they have a number of majority votes associated with their shareholding in the company and if they altered their article by laying down the conditions for which the majority of votes is required than it becomes easier for them to pass every resolution even without giving significance to the consent of the minority shareholders. Therefore, amendment of articles must be in the genuine interest of the company and should not be done for the need of few shareholders (majority) only. It not necessary that it must have the agreement of all the shareholders, but it cannot be used by the controlling majority to discriminate between them and the minority. One cannot amend the articles to give preference only to a specific group of shareholders as it is equivalent to committing fraud on the minority implying malafide on the part of the majority, not for the benefit of the company as a whole. Some of the other famous instances where the opinion of the minority shareholder have been neglected by the majority are as follows-
1. In case of Madhava Ramchandra Kamath v. Canara Banking Corporation, a resolution was passed expelling a member and authorising the director to register the transfer of his shares without the instrument of transfer, the court held the resolution to be invalid as being against the provisions of the act. Therefore, the alteration so done should not be contradictory with any of the provisions of the Companies Act or any other statute. Moreover, the alteration must not be violative with an order of the Company Law Tribunal u/s 397 or 398 of the Companies Act, 1956. Therefore, if the Company Law Tribunal has made any amendment in the articles, then the company cannot alter it making it inconsistent with such order, as the same would amount to contempt.
2. In the case of Allen v. Gold Reefs of West Africa Limited, the company had a lien on all shares, not fully paid-up‟ for calls due to the company. There was only one shareholder named Allen who owned fully paid-up shares. He also held partly paid shares in the company. After Allen died, the company altered its articles deleting the provision “fully paid-up” and thus giving itself a lien on all shares whether fully paid-up or not. Such alteration was challenged on the grounds that it had a retrospective effect. The Court held that the alteration was bona fide and for the benefit of the company as a whole, despite the fact that it had a retrospective effect. Hence, the alteration must be bona fide and should benefit the company as a whole. And if such alteration inflicts hardship on an individual shareholder it should not be outside the ambit of the benefit of the company.
3. In case of Mathrubhumi Printing & Publishing Co. Ltd. v. Vardhaman Publishing Ltd.15, the Kerala High Court held that the power conferred on the company u/s 31 to alter the articles by special resolution is not to be abused by the majority of shareholders so as to oppress the minority. It was also observed by the court that no majority of shareholders can, by altering the articles retrospectively, affect to the prejudice of the consenting owners of the shares. Therefore, such alteration which is not for the benefit of the company as a whole but for the majority shareholders would be bad and must not give rise to any kind of discrimination between the majority and minority shareholders in order to give the former undue advantage over the latter. It has been also observed that a company cannot defeat or escape from its contractual obligation with any person by merely altering its articles. The company will always be liable for damages in case the alteration results in a breach of the contract which the company had entered into with any person.
4. In case of Scottish Co-operative Wholesale Society Ltd. v. Meyer the appellant company and a co-operative wholesale society desiring to enter the rayon trade, formed a subsidiary company to enable it to manufacture and sell rayon materials for which licences were then required. The two respondents, Meyer and Lucas, were appointed managing directors of the company and took up almost half the issued shares. The rest was held by society, which appointed three nominee directors. The company and the society co-operated under a scheme whereby the society purchased the rayon yarn, wove the cloth and sold it to the company for dyeing and finishing, the company is dependent for its supplies upon the society’s mill. Under this arrangement, the company prospered for several years. However, in 1951 a serious dispute arose between the society and the respondents concerning a proposed realignment of the company’s shareholding. Unhappily for the respondents, at about this time rayon licensing controls were lifted so that the society no longer needed them to get supplies of yarn and proceeded to form within itself a department capable of carrying out the company’s functions. The society then set out to destroy the company by diverting to its own department the material produced by its mill and refusing to supply the company with material except at higher and non-competitive prices. The nominee directors, although aware of this policy, did not inform the respondents, but maintained “masterly inactivity”. In consequence, the company’s business came to a standstill and the value of its shares was greatly reduced. In 1953 the respondents presented a petition under s.210, as a result of which the court ordered the society to purchase the respondent’s shares at Pound 3/15/0 per share. This order was unanimously affirmed by the House of Lords.
After perusal of the aforementioned well-settled precedents wherein the minority shareholders have been defrauded by the majority and their interests have not been taken into account; for the protection of their rights, the provision of entrenchment has been recognized and incorporated by the Government in the Indian Companies Act of 2013 though it has not been defined anywhere in the act but has been kept open for interpretation for the judiciary. Also, there has been no litigation in the matter of dispute regarding entrenchment clause since its incorporation in the act of 2013, but there are various other previously held case laws that portray the manner in which the minority shareholders have been oppressed in all the possible different ways which make it one of the main object to inculcate the above provision in the act. If taken a closer look at it, the Government has left it to the discretion of the company whether to amend the articles and add the entrenchment clause or not. But in my opinion, the same can be mandated so that the concept of egalitarianism is followed and the minority shareholders are given an equal sense of voice in the functioning, controlling and decision-making process of the company as given to the majority shareholders. Though every aspect has its pros and cons, it is recommended that these provisions needs to be effectively implemented by both minority and majority shareholder in the interest of the company and for all the stakeholders.
Frequently Asked Questions:
1. What is an article of association of a company?
The article of association is a document that specifies the regulations for a company’s operations and defines the company’s purpose. The document lays out how tasks are to be accomplished within the organization, including the process for appointing directors and handling of financial records
2. Are articles of association legally binding?
Articles of association are rules governing the internal affairs of a company. All registered companies must have articles of association. Every company is required to have articles by law and the articles are legally binding on the company and all of its members.
3. Are articles of association public documents?
The articles are a public document open to inspection at Companies House. They create a contract between the company and each of its members in their capacity as members. Companies have freedom in drafting their articles although they are subject to relevant provisions of the Companies Acts.
4. What are entrenched articles of association?
A company’s articles may contain a provision (“provision for entrenchment”) to the effect that specified provisions of the articles may be amended or repealed only if conditions are met, or procedures are complied with, that are more restrictive than those applicable in the case of a special resolution.
5. Can Articles of Association be altered?
Subject to the provisions of this Act and to the conditions contained in its memorandum, by special resolution, a company may alter its articles. A private company is also prohibited from altering its articles if the alteration is inconsistent with the requirements of section 12 of the Companies Act.
6. Can articles of association override Companies Act?
Companies Act Overrides Memorandum & Articles Of Association. Section 6 of the Companies Act 2013, talks about the cases where Companies Act overridesMemorandum and Articles of Association. in any resolution passed by the company in general meeting or by its Board of Directors.
Edited by – Sakshi Agarwal
Approved & Published – Sakshi Raje